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The last month has provided conflicting messages out of China’s healthcare system regarding its hospitality towards foreign investors as well as foreign pharmaceutical and medical device multinationals. On one hand, in late May, China’s regulators announced additional reforms that will further open up the country’s hospitals towards foreign direct investment (FDI). On the other, the Chinese government’s ongoing pursuit of GSK specifically, broader allegations of price fixing by Johnson & Johnson and Bausch & Lomb, as well as a new round of visits by Chinese authorities to the offices of foreign pharma all point towards a growing willingness by China’s officials to use the its regulatory system to drive prices down. The former set of reforms seems to suggest greater openness towards foreign investment and expertise; the latter actions, at least at first glance, seem to suggest quite the opposite.

In late 2011, China announced it would be modifying its FDI catalog to allow foreign investment into its hospital sector. As with past relaxations of formerly FDI-restricted areas, the initial excitement that greeted this announcement was quickly tempered when it became obvious many restrictions would remain limiting which countries FDI could come from, and the maximum foreign ownership percentage allowed. In the two years following this announcement, several billion dollars from private investors have flowed into China’s hospitals; however, domestic entities have made almost all of the investment. With very few exceptions, foreign capital has stayed on the sidelines, looking to make investments in China’s hospitals, but wary until the rules become more transparent and accommodating towards foreign money. Last week’s reforms made important progress in these areas, promising not only fewer geographic limitations on where FDI could originate, but also providing additional details on how 100% foreign ownership of hospitals would work.

Also in 2011, the changing nature of the pharmaceutical market in China came into sharp focus. For some time, it had been increasingly clear to both domestic and foreign pharmaceutical manufacturers that China’s funding mechanism for its public hospitals is badly broken. Going all the way back to the country’s first attempts at economic reform, public hospitals have been starved of government funding. This has meant they have had to resort to alternative ways to pay their bills. The predominant way this has been accomplished was through the unspoken expectations that families would pay doctors “red envelopes” – essentially off the books cash payments to receive care. In addition, companies would financially incentivize doctors and hospital administrators for prescriptions. Even with this sub-current of payments, the system remained badly overworked, doctors continued to be underpaid and hospitals had no choice but to find alternative ways to monetize their patient census.

These off-book payments mean that one of the most visible places where Chinese families most directly experience favoritism and corruption is when they access healthcare. A broken reimbursement system between China’s hospitals and doctors has created a perverse set of incentives that has led to over-prescription of drugs, un-necessary diagnostic procedures, and inflated prices. Families recognize this, and yet in a moment of personal vulnerability, feel they have no real choice but to pay. The frustrations this has created explain the over 18,000 incidents of personal violence towards doctors and nurses that occurred last year in China’s hospitals. As a consequence of this all, hospitals specifically - and healthcare more generally - pose a unique political problem to the Chinese government.

For the last several decades, multinational pharmaceutical and device companies have benefited from the rise of China’s middle class and their ability to spend out of pocket money for healthcare. At the same time, international hospital operators and private equity firms are eager to get a shot at the Ministry of Health’s public-to-private mechanism that allows for the privatization of China’s public hospitals, a relatively new set of policies that would seem to be very friendly to the private sector. However, what has become frustratingly clear to both the hospital and pharma sectors is how deeply under-resourced China’s public health system is, and as a consequence of this, where the political liabilities in China’s healthcare system are likely to complicate their ability to navigate the opportunity.

The dysfunction within China’s healthcare system lays bare the trade Chinese families have had to make for economic growth. The relentless pursuit of industry, construction and economic activity has meant a blind eye towards pollution of every tangible item that touches their lives: the air they breathe, the water they drink and the food they eat. The health consequences of this exchange are only now coming into focus for both policy makers and families. The mounting cost burden related to China’s cancer and cardiac problems pose one of the most basic threats to the country’s economic future, one the government has only turned its attention to in 2009, when China’s national health insurance program was upgraded and expanded nation-wide. For all the investment made during China’s 2009 health care stimulus and the ensuing plans laid out in the 12th Five Year Plan, healthcare access and affordability remain problems that have no simple solutions.

Within the hospitals’ walls China’s various acute problems converge: a large number of oncology and cancer patients whose disease has been triggered by all-encompassing pollution require care neither the government nor Chinese families are positioned to pay for, unless the latter is able to pay what amounts to bribes. For most of the last fifteen years, the prevailing wisdom about China has been that GDP growth less than 9% would trigger both economic and political problems. Other contrarians have pointed to China’s uneven protection of social liberties and the often heavy-hand of the government on dissenting voices as reasons to believe the China story might end badly. Yet, for all this conjecture, China has managed to work its through economic and political barriers that were once thought to present terminal problems.

Healthcare may be the fundamental political liability to the Chinese government over the course of the next decade. Because the country’s healthcare system exposes the many ways in which Chinese families believe their government has failed to protect them, this space will remain a political minefield for investors. In large part this explains the two different trajectories for hospital and pharmaceutical reforms. Today, simply because China’s hospitals are so badly overworked, the government needs foreign investment and expertise in this area. Consequently, the attitude within the hospital market is one of greater openness and tolerance; however, because these same hospitals rely on private patients to pay out of pocket for many medicines and procedures, foreign products that are perceived to be “too expensive” will remain a target for organized government action. Investors and multinationals will need to be clear on this point: both hospital and pharmaceutical reforms are designed to address the political liabilities within China’s healthcare system. The reforms are not designed to be inherently friendly to the private sector; rather, they are designed to protect the public’s opinion about the role the Chinese government plays providing healthcare to its people. Reforms in China’s hospital sector are, at least for the moment, very amenable to the private sector. Reforms in China’s pharmaceutical space are not. These trajectories may well converge, only to go in completely different directions if political realities make such adjustments necessary.

In both sectors, China is aggressively pursuing policies it believes will improve access and affordability. However, unless it is able to solve the basic problem in China’s public hospitals – a lack of government funding – the only remedy at its disposal will be to become increasingly aggressive on pricing of pharmaceuticals, medical devices and diagnostics. This will take the form of increased anti-monopoly charges and anti-bribery campaigns, all designed to extract cost savings. At the same time China’s hospitals will be opening to foreign investment, the products consumed within the hospitals themselves will be coming under increased scrutiny and price pressure.

Last summer’s pharmaceutical crackdown was surprisingly successful at achieving both price concessions and providing the public with a scapegoat. Unless China can solve its fundamental problem around a broken funding mechanism within its government run hospitals, potential foreign investors in the country’s hospitals run the risk of becoming a target down the road for a frustrated populace and a government eager to find other parties to blame for problems of its own making. The experience pharmaceutical and medical device companies have had in China over the last eighteen months should suggest caution by foreign hospital investors, simply to ensure they understand the unique political concerns at play both in China’s hospital system in general, and more specifically the motivations of Chinese regulators as they seek out foreign capital and expertise within domestic hospitals.